A collapse in growth and precipitous drop in inflation could of course make the earlier rate cut bets pay off, but for now the assessment at the ECB, which we would tend to agree with, is that tentative signs show that Europe’s hardest hit sectors in Germany could be bottoming out.
The German IFO sentiment indicators for example are not good, but they have stopped their steep descent. Likewise, the survey indictors from China, which is so vitally important for German manufacturers.

The Bank of Japan’s (BOJ) October policy meeting is shaping up to be a watershed event; a forecast round wherein improved inflation projections for 2024 and 2025 should open up an early 2024 window for a positive policy rate for the first time in seven years.

By the time of the October 30-31 BOJ meeting, officials expect to have price data and preliminary guidance on the outcome of next year’s Spring wage negotiations that provide a crucial piece of evidence to confirm the central bank has met its price and wage goals.

Bottom Line: As we have written repeatedly, the improved growth outlook has upended the expected drift downward in yields typical at the end of the cycle. The Fed’s place in this story is just as we expected before the FOMC meeting. It sees enough in the employment and inflation data to hope that it hiked rates in July for the last time, but it intends to respond to faster growth with at a minimum of more “higher for longer” and even higher rates if needed. We need to see weaker growth to change this story.

While Ueda’s comments last week did not exactly fling the door open to a rate hike this year, his guidance represented a sharper tilt by the BOJ toward higher rates than at any time in almost 25 years.
And, though we have consistently written this year that a rate move is not likely until next year, equally we have flagged the need to be on guard for signals from Ueda that could point to a BOJ pivot that could come before the second quarter of 2024.
Even if Japanese politics sideline BOJ rate action this year, we continue to caution clients not to dismiss the possibility that the BOJ brings forward a move to end negative interest rates which are at minus 0.10 bps.
When asked about the timing of a possible interest rate adjustment, Ueda said: “It is not impossible that we will have enough by the end of the year to anticipate (wage hikes next spring).”

That said, Powell will still note that faster growth could slow the return to price stability and, if it continues, that could warrant another rate hike. I think the Fed will want to see if the third quarter growth spurt sustains momentum in the fourth quarter before deciding if another rate hike is necessary. Such data likely won’t be available until the December FOMC meeting at the earliest. I also expect the usual hawkish talk about the job not being done and a reminder that inflation progress could reverse as seen more than once in this cycle.
I think the Fed retains another rate hike in the 2023 dots. The balance of risks favors some downward drift in the distribution of the 2023 dots, but I think the improved growth outlook will justify retaining that last rate hike in the SEP. The risk is that the last dot disappears, although that would be akin to a declaration that the cycle is definitely over.
The improved growth outlook all will reduce the number of projected rate cuts in 2024 compared with the June SEP. The easy way to think about this is that the Fed’s forecast will simply push forward the slowing that was anticipated for the second half of 2023. If the Fed pushes it back three months, it probably delays the timing of the first rate cut in the next cycle by a quarter, which then translates into 75bp of cuts for 2024. If the Fed pushes forward the slowdown by six months, the risk is that the Fed will then expect only 50bp rate cuts in 2024.

The ECB has every reason to convey a far more tempered stance at this juncture, and a hope that this could be it for rate hikes, and that time, especially if inflation eases and thus real rates stay tight, will now be on their side.
But we suspect that our “hawkish lean” still lurks as well in the Governing Council very close beneath the surface.
With just one inflation print between now and October, that meeting will clearly be a hold. But we doubt that the decision at hand by December will be whether and when to cut, but rather an assessment of whether the ECB has done enough, as Lagarde said today, “to reinforce” the trajectory of easing inflation that it has penciled in for 2024 and through 2025.

Markets are still favoring a pause and are pricing a European Central Bank rate hike this week at less than even odds.

But we are switching our expectations for the ECB interest rate decision this Thursday from a pause to a 25-basis points hike.

The more we re-run in our minds what we have heard from ECB officials, wargame their tactical choices, and analyze the data and risk management dynamics that will be debated at the Governing Council meetings tomorrow and Thursday, the less comfortable we are with our briefly held, and highly unusual for us dovish call that they will pause at this meeting.

The forecasts, as characterized by ECB Vice President Luis de Guindos, are likely to show a lower growth trajectory than expected in June, and an inflation outlook that is “more or less” as expected in June.

Putting a finer point on that inflation outlook, analysts expect that is likely to translate into a slightly higher figure in the near term, and perhaps a small tweak lower to the 2.2% outlook for 2025 due to slower economic activity. But even a small revision to 2025 inflation, if it does show up in the numbers, will be insufficient progress for ECB hawks, and the leadership, to hang their collective hats on.

Bottom Line
It’s always risky to shift a position on a call where the market odds are sitting at 50-50, and perhaps even risky ahead of a CPI report. It’s a space where it is easy to find yourself on the other side of your own call with each new data point. After all, the odds are 50-50 for a good reason. The data is stronger than expected and the Fed has highlighted that stronger than expected activity could lead it to hike rates again. At the same time, however, lower inflation reduces the urgency to hike rates again, and the Fed is balancing policy against these two considerations. While my optimism hasn’t change, and indeed the data flow has supported the growth story, the tone of the conversation now leads me to believe that even with growth coming in faster in the third quarter, as long as core inflation stays low in these next two prints, the Fed will believe it can wait past the Oct/Nov meeting until it has much more visibility on the fourth quarter to decide if it needs to push rates up another notch.

The Canadian and Australian central banks, either finishing out or done with tightening, are turning their attention to how to fend off growing speculation that rate cuts will be brought forward – in Australia’s case, to early next year.

In Canada too, where the Bank of Canada (BOC) has not yet declared its 2% inflation goal in sight let alone attained, markets are assuming that with a headline CPI inflation rate at 3.3% in July, the BOC has topped out at a cycle peak of 5% and are expecting the BOC to cut rates by the summer of 2024.

This is notwithstanding important data in the interim including Friday’s release of second quarter GDP, forecast to have grown an annualized 1.2% in the second quarter from 3.1% a year earlier. If it fails to show growth moderating in line with the BOC’s projection of an annualized 1.5% rate, it could raise the odds of another hike sometime this year.
To be clear, while we see 5% as the BOC’s policy peak, the BOC noted in July persistent excess demand, reflecting its intention to hold rates higher and for longer than markets are pricing.


...The Canadian and Australian central banks, either finishing out or done with tightening, are turning their attention to how to fend off growing speculation that rate cuts will be brought forward – in Australia’s case, to early next year.

The RBA is just as cautious regarding the path to 2% inflation, notwithstanding this week’s stark slowing in July inflation data that has markets already tipping the RBA is done at its 4.1% cash rate.
While we agree the RBA won’t move rates again at its September 5 policy meeting, it is more likely than Canada to finish out its cycle with a final 25bp-hike, to 4.35%, though not until its November 7 policy meeting, a few days ahead of the November 10 release of the upgraded economic projections.

Battlelines Drawn Heading into Powell’s Speech
Bottom Line: The Fed wants to be done as every rate hike increases the risk of a hard landing. I don’t think the Fed was committed to an Oct/Nov rate hike at the July FOMC meeting, but that’s because it had a very pessimistic outlook for growth at that time. And I think participants were very confident in that outlook, but incoming data has shaken that confidence. Reiterating our outlook, our baseline going into Powell’s speech is that he wants to say, “policy is in a good place,” but he can only really be confident this will hold at the September FOMC meeting. Thinking beyond September, I think he will recognize that the possibility of an upside surprise to growth means the Fed “may have more work to do.” It doesn’t make sense to take that option off the table now given that the Oct/Nov meeting is still a long time away and in theory the data could cut decisively either direction by then.

Many economists and analysts, however, are sticking with their calls for another ECB rate hike. They point to the underlying price components of the PMIs that do not paint a pretty picture and reinforce concerns over the durability in particular of service sector inflation.
Expectations in the forecasting community are that the preliminary Eurozone August CPI figures that will be released next week will paint a similar picture of stickiness in core prices, with most forecasts showing just slight improvement from July’s 5.5% reading.
While they may be right on the data, we no longer agree with the call for a September hike and now expect that the ECB will take a pass and leave rates unchanged at 3.75% at their upcoming meeting

Bottom Line: The Fed is walking a fine line here. Despite disinflation trends, it has proven difficult to keep rates from rising in the absence of softer growth data. It’s not evident, however, that the Fed wants conditions any tighter, but at the same time sending that signal could backfire in the form of higher inflation expectations. Without a catalyst to refocus market participants on downside risks to the economy, there looks to be room for rates to break still higher

The Fed’s Forecast is at Odds with Reality
at the time of the July meeting, the Fed anticipated growth would continue to slow, and below trend growth is a prerequisite to restoring price stability. Second, the Fed’s growth forecast is quickly turning into a complete disaster.
I think we need to have an honest but harsh conversation about the second point in particular. The Fed’s GDP forecast in the June SEP was at best dead on arrival, and at worst simply ludicrous. It implied basically no growth for the second half of 2023, which was plainly wrong even at that time. It required a sudden stop in the economy that just clearly was not happening when those forecasts were made. That forecast was in June, at which point the Fed staff should have known with almost 100% certainty that growth wasn’t falling off the cliff.
Before the Fed minutes were released, the Atlanta Fed raised its estimate of Q3 growth to 5.8%. Even if the reality is half that number, it’s still a major forecasting error on the Fed’s part, and we have been pounding the table for weeks that the Fed has completely underestimated the strength of the economy. Granted, I understand in theory I might need to eat my words on that at some point, but I feel pretty safe for now given that we are already halfway through the third quarter with no sudden stop evident. And if growth is that fast in Q3, I suspect it will retain that momentum in Q4 and put a January rate hike on the table.

Despite what looks like still solid growth in Q3, low inflation keeps the Fed on track for holding rates steady at the September FOMC meeting. I think the growth will be strong enough to keep another rate hike in the SEP and that more likely than not, the Fed will deliver that hike at the Oct/Nov meeting.

....If You Don’t Have Time This Morning
Despite what looks like still solid growth in Q3, low inflation keeps the Fed on track for holding rates steady at the September FOMC meeting. I think the growth will be strong enough to keep another rate hike in the SEP and that more likely than not, the Fed will deliver that hike at the Oct/Nov meeting. That said, I suspect the Fed also worries that policy is getting too tight, and hence we get mixed messaging that “maybe we need another hike, but rate cuts will be on the table in 2024.” The Fed can’t let policy become too tight if it wants to stick the soft landing, but I don’t think it can change its reaction function without letting inflation expectations rise. I don’t think sticking the soft landing will be as easy as the consensus increasingly appears to suggest.

The Fed will raise interest rates 25bp at this week’s FOMC meeting. The outcome of this meeting was effectively determined at the June meeting, something the Fed will deny but has been plainly evident in the signaling in the subsequent weeks. There has been no pushback against market pricing whatsoever during the intermeeting period, and the Fed doesn’t like to surprise markets. Moreover, failure to follow through on a rate hike would be equivalent to a substantial easing of financial conditions. It would rewrite the narrative around the path of monetary policy and bring forward rate cuts

...Monday Morning Notes, 7/24/23
The press conference is an opportunity for Powell to clarify the Fed’s reaction function. The Fed will discuss the conditionality around the timing and extent of further rate hikes at this week’s meeting. We think that Powell will lead market participants to broaden their focus beyond the inflation numbers by explaining that for the Fed to be confident it will restore price stability, it needs to see further cooling in demand evidenced by GDP growth slowing substantially, softer job growth, and further downward pressure on wage growth.

As might be expected, Premier Li also said at the meeting that stabilizing the real estate sector is one of the priorities of governments at all levels for H2 2023.

The State Council has solicited ideas from megacities such as Shanghai and Beijing. As both cities reported double-digit growth in real estate investment and new home sales in H1, the State Council will not adopt a national real estate stimulus policy, but will rather support first, second, and third tier city efforts to improve city-specific policies according to individual situations.

...As might be expected, Premier Li also said at the meeting that stabilizing the real estate sector is one of the priorities of governments at all levels for H2 2023.
The State Council has solicited ideas from megacities such as Shanghai and Beijing. As both cities reported double-digit growth in real estate investment and new home sales in H1, the State Council will not adopt a national real estate stimulus policy, but will rather support first, second, and third tier city efforts to improve city-specific policies according to individual situations.
In order to support the real estate sector in super-large and mega cities, the State Council also just ordered all 21 of these cities to promote the construction of both “Emergency and Dual Use” facilities in H2 2023, recreational facilities that can be used also in case of pandemic and emergencies. The State Council also ordered all 21 super-large and mega cities with a population greater than 5 million to speed up the transformation of the lower income “cities within cities,” to ensure the stability of the national real estate industry in H2 2023.


In order to support the real estate sector in super-large and mega cities, the State Council also just ordered all 21 of these cities to promote the construction of both “Emergency and Dual Use” facilities in H2 2023, recreational facilities that can be used also in case of pandemic and emergencies. The State Council also ordered all 21 super-large and mega cities with a population greater than 5 million to speed up the transformation of the lower income “cities within cities,” to ensure the stability of the national real estate industry in H2 2023...

...Going straight to the numbers, fiscal spending for H2 was bumped up from the original budget and is targeted to increase by just under 7%, 6.9% to be precise, from H1 spending.

In H1 2023 China’s fiscal spending rose 3.9% over the same period last year, to 13.39 trillion yuan. This 13.39 trillion-yuan figure, comprised of 1.67 trillion in central government spending and 11.72 in local government spending, represents 48.7% of the total 27.51 trillion yuan allocated for 2023, leaving 14.12 trillion yuan for H2 spending.

Thursday’s CFEAC meeting approved an additional allocation of 200 billion yuan to H2 2023 spending, to bring the total spending for H2 to 14.32 trillion yuan, about 7% higher than fiscal expenditures for H1. The extra 200 billion yuan also symbolically bumps year-on-year comps by more than 1 trillion above the 13.17 trillion that was spent in H2 of 2022, by 1.15 trillion to be precise.

The CFEAC predicts that these levels of spending will pull China’s H2 GDP growth into the 5.3-5.5% range.

The additional 200 billion yuan will be allocated as follows: 11.5 billion to subsidize targeted semiconductor and artificial intelligence enterprises, 52.5 billion to advance the “transformation of villages in super-large and mega cities,” essentially urban slums, 55 billion to spur the private economy, and 81 billion towards stimulating consumption. Local governments are urged to encourage more nongovernmental investments, including in integrated circuits, new materials, and next-generation information technology.

The CFEAC meeting stressed that fiscal policy should also be used to extend the duration of temporary policies such as value-added tax relief for micro and small-scale taxpayers.

Premier Li Qiang pledged an additional 46.5 billion yuan towards meeting the country’s “Made in China 2025” high tech objectives, of which 35 billion yuan will come from the secretive “Premier Fund.”

As might be expected, Premier Li also said at the meeting that stabilizing the real estate sector is one of the priorities of governments at all levels for H2 2023.

...Conditions are falling into place for the Bank of Japan (BOJ) to tweak Yield Curve Control (YCC) again as the central bank takes its first tangible steps toward exiting a quarter-of-a-century-old easy policy equilibrium.

Since he landed back at the Bank of Japan (BOJ) in April as governor, Kazuo Ueda has been dropping clues about conditions under which he would change Japan’s monetary policy settings.

While at its policy meeting last month, Ueda and his BOJ colleagues held fast to their position that preconditions for changing interest rates had not yet been met, they have been less clear about what might prompt the BOJ to again widen the control cap on 10-year Japanese government bonds (JGBs).

The Bank reiterated that rates would stay put until inflation is stably and sustainably at 2%, and accompanied by wage rises.

Its July 27-28 forecast round will likely raise the fiscal 2023 (Apr-Mar) inflation projection above 2% from 1.8% in the April round, yet continue to show inflation slowing from fiscal 2024.

On YCC, when BOJ Deputy Governor Shinichi Uchida was asked about the possibility of a tweak, he said an adjustment would seek to maintain “easy monetary conditions, while taking into account (the) impact on financial intermediation and market function.” By failing to rule out the prospect of a tweak, Uchida in fact fueled speculation it was in the offing this month.

We have been warning that the BOJ might look to tweak its YCC policy again this meeting before it abandons the program later this year(see SGH 6/13/23; “BOJ: Ueda Games Exit Timing”)...

...While at its policy meeting last month, Ueda and his BOJ colleagues held fast to their position that preconditions for changing interest rates had not yet been met, they have been less clear about what might prompt the BOJ to again widen the control cap on 10-year Japanese government bonds (JGBs).
The Bank reiterated that rates would stay put until inflation is stably and sustainably at 2%, and accompanied by wage rises.
Its July 27-28 forecast round will likely raise the fiscal 2023 (Apr-Mar) inflation projection above 2% from 1.8% in the April round, yet continue to show inflation slowing from fiscal 2024.

The Fed will on average maintain hawkish rhetoric until well past the July FOMC meeting as it is committed to that next rate hike. In general, Fed speak this week has closely followed the message of the SEP. For example, Cleveland Federal Reserve President Loretta Mester said her rate projection was in the median or a little above and San Francisco Federal Reserve President Mary Daly who said “We’re likely to need a couple more rate hikes over the course of this year to really bring inflation.” Richmond Federal Reserve President Thomas Barkin added this after the report:
“Inflation is too high,” Barkin said Wednesday in Arnold, Maryland. “If you back off too soon, inflation comes back strong, which then requires the Fed to do even more.”
When Fed speakers say “inflation is too high,” they are referring to the year-over-year numbers. I suspect, however, that market participants will take their cues from the month-over-month numbers. The Fed’s focus on the year-over-year numbers allows it to maintain a hawkish bias, reinforce the case for a July rate hike, keep the Oct/Nov option open, and push back on expectations of rate cuts anytime soon, but market participants know that year-over-year measures often hide turning points evident in monthly changes. It will be hard to keep market participants focused on a hawkish bias if we get another soft inflation print. That puts more weight on the growth outlook to keep the threat of an Oct/Nov hike alive.
Bottom Line: Arguably, today’s inflation print is only one number, but assuming it becomes a near term trend, the Fed will be more challenged to keep hiking rates after July. This is especially the case given its view that falling inflation creates tighter monetary policy. Being that I am optimistic on growth, I still see the story for another rate hike after July, but realistically the bar is higher after this inflation print. Still it’s a long time until the Oct/Nov meeting. We will need to wait and see how growth, employment, and wages evolve in the months ahead to tell us if any near-term disinflation is sustainable. And, of course, if inflation reverses course as it has in the past, the Fed won’t hesitate to keep the rate hike cycle alive. That said, in the near-term I suspect markets participants will try to run with the soft-landing story.

If You Don’t Have Time This Morning

With a July rate hike already priced in, the focus of market participants will be on what happens next. We will be looking for Fed speakers to give any hints that confirm or deny our baseline expectation that the Fed’s bias will lean toward hiking again after July if growth doesn’t slow more meaningfully.

...Market pricing has moved in our direction in recent weeks. Encouraged by strong data despite expectations of softer inflation numbers, market participants now expect roughly another 1.5 rate hikes this year while yields across the curve have largely retraced the post-SVB declines.
If inflation softens as expected, it may be challenging to take yields up another leg. Although I have high confidence in another rate hike after July, it’s hard for markets to price that in ahead of the supportive data. The Oct/Nov meeting is a long way off with lots of data between now and then.

The Fed staff are pushing a dovish message up to the Board members. It’s hard not to see this research as an effort to warn that the lagged impacts of policy will soon catch up to the economy. In the last two weeks, Fed staff have published notes saying excess savings in the US has been depleted and presumably then it no longer serves a cushion for the economy, that the percentage of financial distressed firms is at a high level, making capital spending and employment vulnerable to tighter financial conditions, and have rolled out a new financial conditions index which estimates that current conditions will drag down GDP by 0.75 percentage points over the next year.

The Fed staff look to be priming the Board to expect soft data, which creates an opportunity if the data is not soft.